Wednesday, February 18, 2009

Bulldoze That House!

It is time for a new Television show, Bulldoze That House! The theme for the show could be done to the tune of Elvis Pressley’s Viva Las Vegas; that gambling town. For gambling is what many home owners have done over the last four years; supplementing their income or the lack there of through no-doc-cash-out-refis on their homes, assuming the free money ride would never end.

Home ownership has always been about more than making the minimum payment, but with teaser rates and “pick-a-pay” loans doing the minimum was all this so-called housing boom was about.

The housing boom was about easy credit rather than economic expansion. While the average American family actually lost purchasing power over the last eight years, easy credit allowed us to maintain the illusion of prosperity while masking the truth: that the American economy has transitioned from higher-wage manufacturing jobs to lower-wage service jobs. That the American economy is based on consumption rather than production.

Since 2004, the basic rules of the housing game were thrown out of the window in an effort to put more and more people into homes. Home ownership was no longer something to aspire to through hard work and sound money management. With the barriers, income, assets, savings, a decent credit score, to home ownership removed anyone and everyone could own a home.

According to the Hoover Institution, home ownership was 66% in the year 2000 and peaked at 69.2% in 2004. The rate of homeownership fell to 67.8% in 2008 and reflects the rising tide of foreclosures in America. According to RealtyTrac, foreclosures have exceeded 250,000 units per month for the last 10 months. If current trends continue, 3 million people will lose their homes to foreclosure over the next year. According to the National Association of Realtors (NAR), there was an inventory of 3.8 million existing homes at the end of December 2008. The NAR estimated that it would take 9 months to work off the existing backlog. The median home price has fallen to $181,000 dollars in part because the numbers of homes bought under distressed conditions such as foreclosure are driving the price of homes down. With an estimated 3 million homes coming on the market due to foreclosure, housing prices have nowhere to go but down.

For ill or for good, home ownership has been considered one of the greatest vehicles for creating wealth in America. The decline in home prices means the loss of wealth that may take a generation to recover.

Already the mythology of the housing downturn is shifting to the economy. Previously, foreclosures were blamed on bad loans not bad borrowers. Now the economy is to blame. The reality is that just over one-third of delinquencies were due to job loss in 2006 and 46% of delinquencies were due to job loss in June of 2008. What this means is that if only the economy were to blame fewer than 1.5 million new homes would be on the market due to foreclosure rather than the projected 3 plus million homes.

Now the banks and borrowers are waiting to see what the Obama administration will do. Borrowers don’t want to lose their homes and banks don’t want to face the truth, that many of their assets are worthless. Municipal and state governments don’t want to lose the tax revenue so everyone is waiting to exhale.

But let’s look at the rules of the housing game: the rules as they were 10 years ago. Ten years ago, a borrower had to show income. Not only did that borrower have to show income, they had to show their qualifying income for at least five years. Ten years ago a first time borrower had to have a down payment of at least 5 percent, earnest money and closing costs. Ten years ago principal and interest payments could be no more than 28% of gross income with total debt payments being no more than 33%. Ten years ago, these were the minimum standards for owning a home.

The reality of home ownership is that it takes more than meeting minimum standards to truly own a home. Homes must be maintained and the cost of maintaining a modestly-priced, three-bed room, two bathroom, home is approximately $3000 per year. Property taxes and insurance payments are guaranteed to increase 3% to 20% per year depending on the market. In other words, a home-owner must have sufficient cushion of three to five thousand dollars per year to truly own their home. If not, a water heater, furnace, landscaping or paint job will become an economic catastrophe.

The reality is that many borrowers do not meet the minimum income requirement or debt to income ratios to remain in their homes. Some borrowers purchased $10 dollars worth of house for every $1 dollar in income. The only way to keep that borrower in their home is to re-price that home to 30% of its original value. Housing prices have not fallen 70% from their peak, therefore how does the government setting a new price bottom so that that borrower can remain in their house help the overall market? It doesn’t. What about the borrower who has significant credit card debt and was slightly over leveraged, borrowing 3.2 dollars for every dollar of income in order to purchase a home? That borrower would be helped by stretching the mortgage term to 40 years. What about the borrower who lost his job after qualifying for a mortgage and found a new job at 80% of qualifying salary? That borrower might be helped by stretching out the term of the loan to 40 years and setting the loan at today’s fixed rate of 5.26%

A borrower purchasing a house today at the median home price of 181, 000 and an interest rate of 5.26% will have a payment of $1000.61 (assuming nothing down). The income to afford that house is $61,000 per year. According to the Census Bureau 25% of US households meet or exceed that income.

The reality is that the government has few tools at its disposal to help borrowers without hurting broader society. Those tools are extending the loan term, re-setting the interest rate, re-pricing the homes, direct subsidies to borrowers. Both re-setting the interest rate and extending the loan term are two solutions that are both sustainable and limit the collateral damage. The contract began with borrowers and the banks and it stays there. Re-pricing the homes extends the damage to neighborhoods and potentially creates a windfall for the delinquent borrower. As an example, look at a borrower with and income of $40,000. That borrower leveraged into a $200,000 dollar home during the housing boom.
In order to afford the home, the borrower took out an interest only loan at the teaser rate of 4.85 percent. The interest-only payment was $808 dollars. The loan resets 5 years later to the prevailing interest rate of 5.26% and the principal and interest are amortized over 25 years. The new principal and interest payment for this borrower is $1199.68 more than 1/3 of monthly gross income. The market has already re-priced homes in the neighborhood to $180,000. Re-pricing the outstanding principal to $180,000, the amount set by market conditions, setting the interest rate at 5.26 percent and extending it over 40 years will make the principle and interest payment $899.00. This borrower might just make it. But the presence of other debts, rising insurance and property tax payments will ensure that this borrower’s economic situation remains tenuous at best. The government then re-prices the home to $150,000 dollars in an effort to keep this borrower in his home. Now the cost to the neighborhood exceeds the penalty imposed by market conditions forcing housing losses in that neighborhood of 25% rather than the market losses of 10%. If this borrower cannot maintain his home, the neighborhood still loses. Direct subsidies to borrowers is a solution without end. At a time when this nation is without a plan to deal with the entitlement obligations of Social Security and Medicare direct subsidies to borrowers is both untenable and unsustainable.

There is a reality that too few people seem to want to face: there are too many homes. In an effort to increase the percentage of home ownership from 66% in 2000 to 69% in 2004, credit flowed too freely and too many homes were built. Cities are populated with unfinished neighborhoods, incomplete apartment complexes, vacant-homes falling into disrepair, and boarded up apartment buildings. Neighborhoods suffer as abandoned buildings house squatters and crime instead of working families. Preferring to board up foreclosed buildings, banks have been loathe to maintain them. Because of the now complex relationships among borrowers, banks and investors, local governments are often unable to locate the parties responsible for a given, abandoned property. It is time for state and local governments, through the power of eminent domain, to take possession of abandoned properties and Bulldoze That House! Local governments could turn the new land into green spaces and community gardens or sell the land for commercial purposes such as bookstores, coffee houses, laundromats. Bulldozing that house is another way to preserve neighborhoods and support housing prices by removing excess inventory. Bulldozing that house also has the added advantage of forcing banks and investors to face their losses and re-price their assets, something they have not done despite receiving billions in taxpayer funds.